Understanding the differences between IAS 39 and FAS 133
It’s easy to dismiss the future mandatory conversion from US GAAP into IFRS rules as none-mission critical, because the go-live date for conversion is 2014 for large accelerated filers and 2015 for everyone else. But the effect of conversion will be felt much sooner, and US companies should keep an eye on IFRS developments as changes in IFRS rules will ultimately affect them as well.
Certainly, right now, 2014 seems far away, and there are so many much more pressing issues on treasurers and accountants’ desks; however, the path to convergence does not begin in 2014. It actually starts a lot sooner. The SEC will require companies to file their first IFRS financial statements in an annual report containing three years of audited financial statements. In other words, large companies must begin to produce audited IFRS statements alongside their US GAAP statements in 2011-2012. And that’s not that far away at all.
The expected transition to IFRS requirements thus puts pressure on treasury and accounting executives to become familiar with a slew of new standards. However, for the sake of this article, we are focusing on IAS 39, the standard that covers derivative and hedge accounting, as well as other areas, which in the US are handled by separate standards, such as FAS 115 (financial instruments), FAS 157 (fair value). The possibly good news is that despite its breadth, IAS 39 is under 200 long, compared to its US equivalents. FAS 133 alone is nearly 1,000 pages long.
Side by Side
Here are a few examples of how IFRS rules and US GAAP diverge, when it comes to derivatives and hedge accounting:
1. Definition of a derivative
Right off the bat, the two standards diverge when it comes to the definition of a derivative. FAS 133 requires that a derivative will have an underlying with one or more notional amounts or a payment provisions to count as a derivative; in addition, 133 says the derivative must require or permit a net settlement, be readily settled by means outside the contract or be settled for a value similar to what it would cost to net settle it.
In contrast, IAS 39 does not require a notional amount and does not require net settlement as a “prerequisite.” While it does say that for a financial instrument to be counted as a derivative it needs to be settled in cash or another financial instrument, the definition of net settlement is much broader. For example, the contract may say “settlement at a future date” and thus be a derivative.
2. What’s hedgeable? Another fundamental distinction between the US and international accounting rules is in the way each defines hedgeable risk. Under FASB rules, hedgers can only designate one of four types of hedgheable risk: benchmark interest rate, credit, foreign exchange or a change in the overall fair value or cash flow. In contrast, the IFRS version is broader for hedges of financial instruments, allowing a company to hedge more specific risk, e.g., hedge only the risk associated with a prime rate-based loan and as such more easily achieve a high degree of effectiveness. Unfortunately, neither IAS 39 nor FAS 133 allow hedgers to selectively hedge non-financial exposures, which remain subject to “overall” change requirements.
3. Partial-term hedging. Under FAS 133, companies may elect to partially hedge a fair value exposure; however, in most cases (hedging the first 5 yrs of a 10 yrs debt), the hedge will very fail to be highly effective and thus, de facto, excluded. In other words, companies can partially hedge, they just won’t get hedge accounting treatment. Meanwhile, IAS 39 says its OK to designate only a portion of the period for which the hedged item is outstanding, which means it’s a lot more likely that the hedge will be highly effective.
4. Time value of an option. Under US GAAP, companies hedging with options have a better chance at being highly effective than companies filing under IFRS. That’s because DIG issue G20 allows hedgers to exclude the time value of he option from effectiveness testing. Under IAS 39, time value must be included when calculating effectiveness. Because the time value is only present in the hedge – not the hedge item – hedgers are less likely to be highly effective and would have to record ineffectiveness.
5. Shortcuts. Initially, the two standards diverged on the issue of whether there are any situations that would permit companies to assume zero ineffectiveness. For example, FAS 133 offered the shortcut method for interest rate swaps and the critical terms match (CTM) for commodity and currency hedges. IAS 39 did not offer similar methods. Overtime, however, FAS 133 morphed into a philosophy closer to IAS 39. Because of perceived abuses and SEC actions, CTM and shortcut have for all intents and purposes been abandoned, replaced with the long haul method, which requires regression nalysis and more granular details.
6. Using a non derivative to hedge: US GAAP limits designation a non-derivative, e.g., foreign currency debt, to fair value and net investment hedging , whereas IAS 39 permits there use in a cash-flow hedging relationship
7. OCI re-classes: Under US rules, when a hedge of a non-financial asset or liability is discontinued (e.g., a hedge of inventory) all balances that had accumulated in OCI must be reclassified into earnings in the same period. Under IAS 39, companies can choose one of two approaches:
8. The changes in variable cash flow method. In this case, US GAAP is more liberal. FAS 133 allows this method for measuring ineffectiveness as long as the swap is at or close to zero. IFRS rules do not allow it under any circumstance. Hypothetical derivative and change in fair value methods described in G7 are acceptable for measuring effectiveness.
- They can take all the balances out of OCI and recognize them in earnings for the period (similar to FAS 133); alternatively
- They can include those amounts in the initial cost basis or other carrying amount of the acquired asset or liability. In other words amounts may be reclassified from OCI to inventory, deferred revenue, fixed assets, etc,
While the SEC has announced its path to IFRS, a couple of recent issues may change the relationship between FAS 133 and IAS 39 in the least, or derail the project altogether.
- The first obstacle is political pressure from EU finance ministers who are frustrated with the asset impairment and fair value measurement criteria in IAS 39. Their point of view was shared with Congress in the US, where, too, there’s been pressure on the SEC and FASB to review fair value measurement guidance under FAS 157. In both cases, politicians were and are concerned that tough fair value measures will force banks and other companies to write down further large losses.
- The next potential obstacle is the FASB shift to a codification method for all accounting literature (see Bulletproof, June 2009). The complete overhaul of the way US GAAP is catalogued and created is forcing audit firms and their clients to overhaul their accounting guides and actual references to specific financial accounting standards in their financial statement. The enormous effort is perplexing given that the IASB has not announced a similar cataloging method, which make conversion more difficult. [I think the FASB thinks this will make integration easier?I don’t think ifrs has eitfs, fins, etc, they just have ias/ifrs
- But that’s not all. FAS IAS 39 was originally created as a temporary measure but has since grown organically and often inconsistently. In early May (in part for political reasons) the IASB announced that it will take a fresh look at three areas in IAS 39 with an eye toward changing them. The IASB plans to completely replace IAS 39 in three phases:
- Quantification and measurement (ED was issued in July)
- Impairment of financial assets;
- Hedge accounting (to be handled after the first two efforts are concluded)
If the IASB manages to stick to its timetable, the new standardswill be ready just in time for US companies to begin to keep IFRS-compliant copies of their financial statements.